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“If you are driving in fog, ice or snow, the most important rule is to keep your distance. It’s rule number one, two, three ... and up to ten. “
This was said to me by the kind person taking us to Zurich airport today. He was referring to driving in winter weather here. For me, it captured perfectly the dilemmas facing the Federal Reserve as it decides by how much it should cut interest rates at the end of this month (yes, it’s not a question of whether they will cut but by how much).
While the US economy faces “cross currents,” it remains in a “good place” (using two of Chairman Powell’s favorite descriptors) – that is, domestic economic momentum is able, at least for now, to overcome headwinds from slowing growth in the rest of the world, trade policy uncertainties, and increasing currency tensions. Yet, judging from Fed Chairman Powell’s remarks to Congress last week, the world’s most powerful central bank is on the verge of cutting rates, thereby also opening the door for central banks elsewhere to ease their monetary policies.
It’s hard to justify a rate cut using traditional metrics. The unemployment rate is at a five-decade low, inflation is not that far below the Fed’s target, financial conditions are the loosest in almost two decades, stock indices are at record highs, and interest rates are already at low levels. Yet the Fed is under tremendous market and political pressure to cut. And it will do so citing the concept of an “insurance cut” – that is, increasing monetary stimulus now in order to reduce the risk of future damage.
But like most insurance you and I get, the one the Fed will embrace is not free for four main reasons:
The more the central bank does now, the less room it will have to cut later if domestic economic momentum wanes. (Remember, the current US economic expansion is already an unusually long one, having also set a new record less month.)
The greater the policy easing, the stronger the signal to investors and traders to expand their risk appetite even more – and this at a time when several indicators of excessive risk-taking are already flashing yellow if not red.
With easing unlikely to have much beneficial economic effects, corporate and economic fundamentals will lag further already-elevated asset prices, thereby accentuating threats of future financial instability that could cause economic harm.
The more the Fed stimulates when the economy is in a good place, the more it will be seen as succumbing to undue pressures from markets and the White House. This could damage its credibility and undermine the effectiveness of its future policy guidance.
The Fed will balance all this at the July 30-31 policy making meeting of its Federal Open Market Committee (FOMC). And with the option of no rate cut practically precluded (as it would likely trigger considerable market volatility and quite a political reaction), the question boils down to whether to cut interest rates by 25 or 50 basis points.
The most probable outcome – and it’s a high probability one – is a 25 bps cut, wrapped in language that keep open the possibility of more reductions later this year, thereby lowering the risk of market and political backlash.
But, make no mistake, the Fed will be paying a premium for this insurance cut; and it’s a premium that could prove material if the economy were to hit a rough patch due to either domestic or external disruptions.
Mohamed A. El-Erian is the chief economic advisor to Allianz, the corporate parent of PIMCO where he served as CEO and co-CIO (2007-2014). A Bloomberg columnist and Financial Times contributing editor, he was Chair of President Obama’s Global Development Council and has authored two New York Times Best Sellers: the 2008 “When Markets Collide” and 2016 “The Only Game in Town.”